Report: Fed & Goldman Sachs Caused Housing Bubble

Those of you who already thought the case on what caused the housing bubble had already been closed, can certainly be forgiven. After all, two years have passed, and numerous articles have already been written. (I profiled two of them here and here on this very blog, which asserted that the bubble was caused by inaccurate assessments of labor productivity and home equity loans, respectively.) Last month, the the Financial Crisis Inquiry Commission (FCIC) concluded its 18 month investigation into the causes of the financial crisis and released the most comprehensive report on the subject to-date.

The brunt of the blame for fomenting the housing bubble was heaped at the Fed, which was criticized both for its easy monetary policy and its lax regulation. In fact, according to just-released minutes from one of the the Fed’s 2005 meetings (there is apparently a five-year lag in such releases), Fed members were aware that a bubble was forming in housing markets, but were basically too complacent to meaningfully address it.

If you recall, the Fed lowered its benchmark lending rate down to 1% in 2001, without worrying about the impact on housing and asset prices: ” ‘I get very irritated when I see columns suggesting that we are trying to inspire or should be trying to prick a housing bubble,” said Fed Governor Edward Gramlich…’There is no way to do that and still maximize the inflation/unemployment outcome. Monetary policy is broad and has broad effects.’ ” Other members concurred that the Fed – or any other government institution – should not have any role in trying to second-guess the “market mechanism.” Thus, even after evidence of the housing bubble began to accumulate,  it was similarly slow in raising rates.

The Fed also took the (erroneous) view that risky mortgage types and predatory lending didn’t merit any serious attention. While Fed Governor Janet Yellen acknowledged that “newer financing options, such as interest-only mortgages, were widely viewed as ‘feeding a kind of unsustainable bubble,’ she ultimately adopted the passive position that, “the increasing use of creative financing could be a sign of the final gasps of house-price appreciation at the pace we’ve seen and an indication that a slowing is at hand.” The FCIC report doesn’t mince words in assessing this failure to act: “The Fed committed a ‘pivotal failure to stem the flow of toxic mortgages, which it could have done by setting prudent mortgage-lending standards. The Federal Reserve was the one entity empowered to do so and it did not.”

In addition to censuring Fannie & Freddie for lowering lending standards and over-leveraging (actually, this was covered more in the official dissent), the report singled out Goldman Sachs for its role in fomenting the housing bubble: “Goldman played a key role by providing billions of dollars in loans to subprime mortgage lenders and then bundling tens of billions of dollars in risky loans into investments.” The report also reminds us that Goldman’s financial engineering “multiplied losses” from the collapse of the housing bubble, and that it profited handsomely from the consequent decline in housing prices.

While economists will certainly continue to argue over the nuances for years to come, it seems the general causes of the housing bubble & bust have thoroughly been fleshed out. For all intents and purposes, the debate has ended. Given that interest rates are once again at a record low, the Fed is fighting to relinquish its regulatory powers, and Goldman Sachs is still minting profits, one wonders whether it even matters over the long-term, and how long it will be before another bubble comes along.